QMF Lectures 2013-14

QUANTITATIVE METHODS FOR FINANCE
alessandro.sbuelz@unicatt.it
Room 221, 2nd oor, Via Necchi 9
Phone: +39-02-72342345
O ce hours: 14:30-16:30 on Tuesday
Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14
TEXTBOOK
Lecture notes.
I
A. BATTAUZ - F. ORTU, Arbitrage Theory in Discrete and Continuous
Time (Cod. 8444), Edizioni EGEA, last edition (available at Libreria EGEA, Via
Bocconi, 8).
I
K. SYDSAETER - P. J. HAMMOND, Mathematics for economic analysis,
Prentice-Hall, 1995.
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I
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I
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COURSE OUTLINE
No-arbitrage pricing of assets replicated by existing traded securities.
No-arbitrage pricing of unreplicable assets.
Constrained optimization with applications to nance/economics.
Equilibrium valuation of assets.
LINEAR ALGEBRA
(REVIEW)
I IS THE NEUTRAL ELEMENT OF THE MULTIPLICATION
I
The n n identity matrix I has 1s down the main diagonal and 0s elsewhere.
The 2 2 identity matrix, for example, is
I =
"
1 0
0 1
2
5 1
"
3
6
7
4 8 3 5
1 0
3 4 0
5 2 2
"
1 0
0 1
"
1 0
0 1
"
2
3 4 0
5 2 2
5 1
6
7
4 8 3 5
1 0
TRANSPOSITION AND MULTIPLICATION
I
If you transpose a matrix product you multiply the transposed matrices in
reverse order:
0
A
Bz
}|
{
B
B "
#
B
B
1 2 0
B
B
1 1 1
B
@
bT
}|
5 8 1
z b}|
1T
C
2
3 C
C
5 C
6
7 C
4 8 5 C
C
1 C
A
{ 2
AT
}|
1 1
6
7
4 2 1 5
0 1
"
21
14
#T
m
{
21 14
i
7
INVERSE AND INVERTIBLE MATRICES
If it exists, the inverse of an n n matrix C is an n n matrix C 1 satisfying

CC 1 = I
C 1C = I :
and
For example,
z
"
C
}|
1 2
1 3
{ z
C 1
}|
"
3
1
2
1
"
1 0
0 1
1 0
0 1
and
z
An n
"
C 1
}|
3
1
2
1
{ z
"
C
}|
1 2
1 3
"
n matrix C is invertible if its inverse matrix C 1 exists.
DETERMINANTS OF SQUARE MATRICES
I
C is invertible if and only if (i ) it is non-singular, that is, its determinant
is non-zero.
det
"
1 2
1 3
#!
= 1 ( 1)1+1 det (3) +

|
{z
}
the 1-1 cofactor
1 ( 1)2+1 det (2)

|
{z
}
the 2-1 cofactor
= 1 3 + 1 ( 2)
1 .
DETERMINANTS OF SQUARE MATRICES
02
31
"
#!
1 2 3
3 2
B6
7C
det @4 2 3 2 5A = 1 ( 1)1+1 det
+
3 2
3 3 2
{z
}
|
the 1-1 cofactor
2 ( 1)2+1 det
|
2 3
3 2
#!
2 3
3 2
#!
{z
the 2-1 cofactor
3 ( 1)3+1 det
|
"
"
{z
the 3-1 cofactor
= 1 (0) + 2 5 + 3 ( 5) =
5
10
CONSTRUCTING THE INVERSE MATRIX
"
1 2
1 3
# 1
=
det
|
"
1
1 2
1 3
{z
=1
#!
matrix of cofactors of
"
1 2
1 3
!T
11
6
6
6
"
#
6
6
1 2
matrix of cofactors of
= 6
6
1 3
6
6
6
4
2
6
= 4
( 1)1+1 det (3)
{z
}
the 1-1 cofactor
{z
}
the 1-2 cofactor
{z
}
the 2-1 cofactor
{z
}
the 2-2 cofactor
3
2
1
1
7
7
7
7
7
7
7
7
7
7
5
( 1)1+2 det (1)
( 1)2+1 det (2)
( 1)2+2 det (1)
3
7
5
12
"
1 2
1 3
# 1
1
1
"
"
3
1
3
2
2
1
1
1
#T
13
A FORMULA FOR INVERTING 2
Given ad
2 MATRICES
cb 6= 0, consider the square matrix

"
a b
c d
cb
"
Its inverse is
1
ad
d
c
b
a
14
INVERTING A 3
3 MATRIX
Show that
6
6
6
6 2
6
6
4
2
3
3
3 1
3
7
7
7
2 7
7
7
5
6
6
1 6
6 2
56
6
4
5
7
3
7
7
7
4 7
7
7
5
15
SYSTEMS OF LINEAR EQUATIONS (REVIEW)
16
A FIRST EXAMPLE
Consider the following linear system in the unknowns x1, x2, and x3 :
8
>
x 1 + 2 x2 + 3 x3
>
>
>
>
>
<
2 x 1 + 3 x 2 + 2 x3 =
>
>
>
>
>
>
: 3x + 3 x + 2 x =
1
2
3
6
1
0
We can rewrite it as follows:
32
1 2 3
x1
6
6
76
7
6
7
4 2 3 2 5 4 x2 5 = 4 1 5
3 3 2
x3
0
17
A FIRST EXAMPLE
We can also rewrite the system as a `constrained' linear combination:
3
2
1
6
7
6
7
6
7
x1 4 2 5 + x 2 4 3 5 + x 3 4 2 5
2
3
3
6
6
7
4 1 5
0
18
A FIRST EXAMPLE
The system admits a solution i the vector
2
6
4
6
7
1 5
0
can be seen as a linear combination of the vectors
6
7
4 2 5
6
7
4 3 5
and
6
7
4 2 5
with proper weights x1, x2, and x3.
19
A FIRST EXAMPLE
This can happen i (Rouche-Capelli Theorem)
1 2 3
6
7
the number of independent columns of 4 2 3 2 5
3 3 2
equals
2
1 2 3
6
the number of independent columns of 4 2 3 2
|
3 3 2
6
7
1 5
0
{z
}
complete matrix
20
A FIRST EXAMPLE
I
has.
The rank of a matrix measures how many indipendent columns the matrix
The rank of a matrix is the highest order of non-singular square submatrices.
1 2 3
1 2 3
6
7
6
4 2 3 2 5 is non-singular so that 4 2 3 2
3 3 2
3 3 2
6
7
1 5 has maximum rank (3) .
0
{z
}
complete matrix
21
A FIRST EXAMPLE
I
We can work out the solution x1, x2, and x3 by means of the Cramer's
Theorem:
02
B6
x1 = det @4
02
1
B6
x2 = det @4 2
3
02
31
6 2 3
C
1 3 27
5A = ( 5)
0 3 2
31
6 3
C
1 27
5A = ( 5)
0 2
1 2
B6
x3 = det @4 2 3
3 3
31
6
C
17
5A = ( 5)
0
5
=1 ;
5
19
=
5
3:8 ;
21
= 4 :2 :
5
22
A FIRST EXAMPLE
I
We can work out x1, x2, and x3 also by means of inversion (given nonsingularity):
3 1
1 2 3
6
7
4 2 3 2 5
3 3 2
3 2
x1
1 2 3
7
6
7 6
4 2 3 2 5 4 x2 5
x3
3 3 2
3 1
1 2 3
6
7
= 4 2 3 2 5
3 3 2
6
6
7
4 1 5
0
m
2
3 2
3 1 2
3
1 0 0
x1
1 2 3
6
7
6
7
6
7
6
7 6
4 0 1 0 5 4 x2 5 = 4 2 3 2 5
4 1 5
0 0 1
x3
3 3 2
0
23
A FIRST EXAMPLE
x
6 1 7
7
6
7
6
6 x 7
6 2 7
7
6
5
4
x3
6
6
1 6
6 2
56
6
4
5
7
3
3 2
7
7
7
4 7
7
7
5
6
6
6
6
6
6
4
7
7
7
1 7
7
7
5
6
6
6
6
6
6
4
7
7
19 7
7
5 7
7
5
21
5
24
A SECOND EXAMPLE
Consider the following linear system in the unknowns x1, x2, x3 and x4 :
8
>
>
>
>
>
>
<
>
>
>
>
>
>
:
x4
= 1
x3 + 2 x4
= 0
x1
x2 + 2 x3
2 x1
x2
x1 + 2 x2 + 2 x3 + x4 = 1
Let's express it as follows:
6
7
6
x1 4 2 5 + x2 4
1
2
1
1
7
6
7
6
7
6
7
1 5 + x3 4 1 5 + x4 4 2 5 = 4 0 5 .
2
2
1
1
25
A SECOND EXAMPLE
The rst three vectors are independent:
02
B6
det @4 2
1
1
2
31
2
7C
1 5A = 9
2
26
A SECOND EXAMPLE
If the fourth vector is brought on the right-hand side,

2
6
6
7
x1 4 2 5 + x2 4
1
2
1
6
7
6
7
7
1 5 + x3 4 1 5 = 4 0 5
1
2
2
6
7
x4 4 2 5
the solution (with one degree of freedom) can be written as
x
1
6 1 7
6
6
7
6
6
7
6
6 x 7=6 2
6 2 7
6
6
7
6
4
5
4
x3
1
1
2
3 1 02
3
2
1
7
B6
7
7
B6
7
7
B6
7
7
B
6
1 7 B6 0 7
7
7
B6
7
5
@4
5
31
6
7C
6
7C
6
7C
6
C
x4 6 2 7
7C
6
7C
4
5A
2 1
5x
3 4
6 3
6
6 2
16 x
6
6 9
9 4
6
4
4x + 4
9 4
9
3
7
7
7
7
7
7
5
27
A THIRD EXAMPLE
Consider the following linear system in the unknowns x1, x2, and x3 :
8
>
2 x1 + 7 x2 + x3 =
>
>
>
>
>
>
>
>
>
< 5 x1 + 6 x2 + 8 x3 =
>
>
>
>
>
>
>
>
>
>
:
9 x2
15
3
= 27
7 x1 + 6 x2 + 7 x3 =
Let's state it as follows:

2
15
6 5 7
6 6 7
6 8 7
6 3
6
7
6
7
6
7
6
x1 6 7 + x2 6 7 + x3 6 7 = 6
4 0 5
4 9 5
4 0 5
4 27
3
7
7
7
5
28
A THIRD EXAMPLE
The rst three vectors are independent because

02
31
2 7 1
B6
7C
det @4 5 6 8 5A =
0 9 0
The last vector linearly depends on the rst three vectors as

02
B6
B6
det B6
@4
99
2
5
0
7
7
6
9
6
31
1 15
C
8 3 7
7C
7C = 0
0 27 5A
7
3
Hence, the system admits solution.
29
A THIRD EXAMPLE
I
We can work out x1, x2, and x3 by focusing on the rst three equations
(given non-singularity):
2
15
2
7
1
6
6
7
6
7
6
7
7
x1 4 5 5 + x2 4 6 5 + x3 4 8 5 = 4 3 5
27
0
9
0
m
3 12
3
15
2 7 1
x1
7
6
7
6
7
6
4 3 5
4 x2 5 = 4 5 6 8 5
0 9 0
27
x3
2
3
7
6
4 3 5
0
The last equation is met by construction:

x1 7 + x2 6 + x3 7 =
21 + 18 + 0
30
ONE-PERIOD FINANCIAL MARKETS
31
TIMING
Investors face two trading dates only, namely t = 0 and t = 1.
At time t = 0, investors choose their investment strategy.
At time t = 1 they receive the liquidation value of their strategy.
I
At time 0, investors can choose among N + 1 securities, for which we use
the index j , with j = 0; : : : ; N .
32
THE RISKLESS SECURITY
The security with j = 0 represents a riskless security.
B (0)
1 denotes the time-0 price of the riskless security.
B (1)
1 + r denotes its time-1 price.
The quantity r is the risk-free rate, with r > 0.
33
THE RISKY SECURITIES
For the N securities with j > 0, Sj (0) denotes their time-0 price.
Sej (1) is a random variable that denotes their time-1 price, with j = 1; : : : ; N .
34
UNCERTAINTY
I
By time 1, the market uncertainty will resolve in one of K possible states
of the world.
I
! k indicates the generic k-th state of the world at time 1.
The ! k 's are relevant economic/ nancial scenarios.
indicates the set of all states of the world, i.e.
= f! 1; : : : ; ! K g.
Sj (1)(! k ) indicates the time-1 price of the j -th security in scenario ! k .
35
THE PAYOFF MATRIX M
The payo matrix M has K + 1 rows and N + 1 columns.
I
Each column j of M represents the out ows/in ows from buying 1 unit of
the j -th security (j = 0; 1; :::; N ):
2
6
6
6
6 1+r
6
6
6
6
6 1+r
6
6
6
...
6
6
6
4
1+r
S1(0)
S2(0)
S1(1)(! 1)
S2(1)(! 1)
S1(1)(! 2)
S2(1)(! 2)
...
...
S1(1)(! K )
S2(1)(! K )
SN (0)
7
7
7
SN (1)(! 1) 7
7
7
7
7
SN (1)(! 2) 7
7
7
7
...
7
7
7
5
SN (1)(! K )
36
EXEMPLIFYING A MARKET WITH 3 SECURITIES AND 3 STATES
Consider a one-period market with N = 2 and K = 3.
Assume that B (1) = 1:05, so that r = 5%.
The time-0 prices of the risky securities are S1(0) = 0:5 and S2(0) = 2:5.
The time-1 prices of the risky securities are

S1(1)(! 1) = 0
S2(1)(! 1) = 0
S1(1)(! 2) = 2
S2(1)(! 2) = 0
S1(1)(! 3) = 0
S2(1)(! 3) = 5
37
EXEMPLIFYING A MARKET WITH 3 SECURITIES AND 3 STATES
The payo matrix is then the following 4
6
6
6
6 1:05
6
= 6
6
6 1:05
6
6
4
1:05
3 matrix:
0 :5
2 :5
3
7
7
7
7
7
7
7
7
7
7
5
38
INVESTMENT STRATEGIES
#0 is the position in the risk-free security.
#1; #2 are the positions in the two risky securities.
I
The positions represent the units of each security bought, or sold short, at
time 0.
39
#1 = 3
(buying 3 units of security 1)
initial out ow:
3 ( 0:5) =
nal in ows:
6
7
6
7
6
7
7
36
2
6
7
6
7
4
5
1 :5
6
7
6
7
6
7
7
= 6
6
6
7
6
7
4
5
40
#0 = 10
(LENDING)
(buying 10 units of the riskless security)
initial out ow:
10 ( 1)
nal in ows:
1:05
6
6
6
10 6
6 1:05
6
4
1:05
10
10:5
7
6
7
6
7
6
7 = 6 10:5
7
6
7
6
5
4
10:5
3
7
7
7
7
7
7
5
41
#2 =
(selling short 2 units of security 2)
initial in ow:
2 ( 2:5) =
nal out ows:
6
7
6
7
6
7
7
26
0
6
7
6
7
4
5
6
6
6
= 6
6
6
4
0
0
10
3
7
7
7
7
7
7
5
42
#0 =
(BORROWING)
(selling short 7 units of the riskless security)
initial in ow:
7 ( 1)
nal out ows:
1:05
6
6
6
76
6 1:05
6
4
1:05
7
6
7
6
7
6
7 = 6
7
6
7
6
5
4
7: 35
7
7
7
7: 35 7
7
7
5
7: 35
43
The generic investment strategy is a (column) vector # 2 R3:

0
#0
B
C
# = @ #1 A :
#2
Let's look at the following strategy # :

0
buying 4 units of the riskless security
B
C
B
B
C
B
B
C
B
C = B buying 5 units of security 1
= B
5
B
C
B
B
C
B
@
A
@
buying 2 units of security 2
C
C
C
C:
C
C
A
44
The market is competitive: no one has price impact.
The market is frictionless:
no indivisibilities
(#is are not only integers);
no short-selling constraint
(#is can be negative);
no trading limits
(#is are unbounded);
no margin requirements;
no bid-ask spreads;
no taxation on capital gains.
45
THE INITIAL COST OF AN INVESTMENT STRATEGY
I
At time 0, the quantity V# (0) is the cost an investor must face to set up
the investment strategy #.
Let's assess the initial cost V# (0) for the strategy # :

0
B
C
B
C
B
C
B
= B 5 C
C:
B
C
@
A
The corresponding initial out ow is
V# (0) :
46
THE FINAL PROCEEDS OF AN INVESTMENT STRATEGY
I
The nal proceed V# (1) (! k ) is the time-1 cash ow in the state ! k from
liquidating the investment strategy #.
Let's assess the nal proceeds of the strategy # .
47
THE STRATEGY FOR GIVEN FINAL PROCEEDS
Let's nd the strategy # whose nal proceeds are:

2
V (1) (! 1)
6 #
6
6
6 V (1) (! )
2
6 #
6
4
V# (1) (! 3)
0 :5
7
6
7
6
7
6
7 = 6 0 :5
7
6
7
6
5
4
0 :5
7
7
7
7:
7
7
5
48
BACK-ENGINEERING STRATEGIES
Find the strategy # whose initial cost and nal proceeds are:
V# (0) = 0;
V# (1) (! 2) = 4;
V# (1) (! 3) = 2.
49
`FREE LUNCHES' ?
They are possible if there are:
violations of the law of one price;
arbitrage opportunities of the rst type;
arbitrage opportunities of the second type.
50
VIOLATIONS OF THE LAW OF ONE PRICE
Two strategies have di erent costs at time 0

despite
providing the same nal proceeds in any state at time 1.
In our market M there are no such violations.
51
ARBITRAGE OPPORTUNITIES OF THE FIRST TYPE

There is a strategy with non-positive initial cost
that
never yields negative nal proceeds
while
granting strictly-positive nal proceeds
in
at least one of the states at time 1:
In our market M there are no such opportunities.
I
For example, let's work out the initial cost of a strategy that pays o nothing
but 1 cent in the state ! 3:
52
ARBITRAGE OPPORTUNITIES OF THE SECOND TYPE
There is a strategy with strictly-negative initial cost

that
never yields negative nal proceeds.
In our market M there are no such opportunities.
I
For example, let's calculate the nal proceed prevailing in the state ! 3 of a
strategy that costs 10 cents and pays o nothing in the states ! 1 and ! 2.
53
`FREE LUNCHES' ARE IMPLAUSIBLE
I
Any non-satiated investor (in the sense that she always prefers more wealth
to less) would exploit these situations.
There would be no equilibrium.
54
THE NO-ARBITRAGE ASSUMPTION
A market satis es the no-arbitrage condition if it does not permit
violations of the law of one price;
arbitrage opportunities of the rst type;
arbitrage opportunities of the second type.
Our market
is arbitrage-free.
6
6
M =6
4
1
1:05
1:05
1:05
0 :5
0
2
0
2 :5
0
0
5
3
7
7
7
5
55
THE RISK-NEUTRAL PROBABILITY MEASURE Q
I
A risk-neutral probability measure Q is made of K probability masses Q (! k )
such that:
Q (! k ) > 0
for any k = 1; ::::; K .
The masses are strictly-positive .
56
2A
Q (! 1) + ::: + Q (! K ) = 1 .
The masses sum to 1 .
57
2B
1
E Q [B (1)]
B (0) =
1+r
=
1
[Q (! 1) B (1) + ::: + Q (! K ) B (1)]
1+r
= 1 .
The masses sum to 1 .
I
For the riskless security, the price is the discounted Q-expectation of the
payo .
58
i
h
1
Q
Sj (0) =
E Sej (1)
1+r
i
1 h
=
Q (! 1) Sj (1) (! 1) + ::: + Q (! K ) Sj (1) (! K ) ,
1+r
j = 1; :::; N .
Prices are discounted Q-expectations of payo s.
59
WHY RISK-NEUTRAL?
The statement
h
i
1
Q
E Sej (1) ,
Sj (0) =
1+r
j = 1; :::; N ,
is equivalent to the statement

"
Sej (1) Sj (0)

Q
E
Sj (0)
= r,
j = 1; :::; N .
Q-expected returns equal the risk-free rate.
60
WHY RISK-NEUTRAL?
I
Under Q, the initial cost of a strategy # equals the discounted Q-expectation
of its nal proceed:
h
i
1
Q
e
V# (0) =
E V# (1)
1+r
The Q-expected return from # equals the risk-free rate.
61
THE FIRST FUNDAMENTAL THEOREM OF ASSET PRICING
The following statements are equivalent:
the no-arbitrage condition holds;
a risk-neutral probability measure Q exists.
62
OUR ARBITRAGE-FREE MARKET ADMITS A Q
The risk-neutral probability masses are:
Q (! 1 )
6
6
6
6 Q (! )
2
6
6
4
Q (! 3 )
3
7
7
7
7
7
7
5
0:212 5
6
6
6
6 0:262 5
6
6
4
0:525
3
7
7
7
7
7
7
5
63
A LONG FORWARD CONTRACT ON SECURITY 2
I
A long forward contract is an agreement to buy the risky security at date 1
at a pre-speci ed price (the delivery price E = 1).
The payo of the contract is

2
f (1) (! 1)
6
6
6
6 f (1) (! )
2
6
6
4
f (1) (! 3)
3
7
7
7
7
7
7
5
S (1) (! 1)
6 2
6
6
6 S (1) (! )
2
6 2
6
4
S2 (1) (! 3)
7
7
7
E 7
7
7
5
6
6
6
6
6
6
4
7
7
7
1 7
7
7
5
64
NO-ARBITRAGE PRICING OF THE LONG FORWARD
The unique strategy that replicates the long forward payo fe (1) is
#f
2
6
4
0:952 380 95
7
0
5
1
I
The no-arbitrage price of the long forward equals the initial cost of the
replicating strategy #f :
V#f (0)
1:547 619 1 .
65
NO-ARBITRAGE PRICING OF THE LONG FORWARD
The no-arbitrage price of the long forward is

h
i
1
Q
e
E f (1)
f (0) =
1+r
h
1
Q
E Se2 (1)
=
1+r
1:547 619 1 .
66
NO-ARBITRAGE PRICING OF A EUROPEAN CALL
I
A European call option on the risky security 2 with strike price E = 1 is the
right to buy the risky security at date 1 at the pre-speci ed strike price.
Find its no-arbitrage price c (0).
67
NO-ARBITRAGE PRICING OF A EUROPEAN PUT
I
A European put option on the risky security 2 with strike price E = 1 is the
right to sell the risky security at date 1 at the pre-speci ed strike price.
Find its no-arbitrage price p (0).
68
THE PUT-CALL PARITY
c (0)
p (0)
f (0)
S2 (0)
E
1+r
69
MARKET COMPLETENESS
70
COMPLETE MARKETS
f (1) is
A payo X
replicable
if there exists a strategy # such that
V# (1) (! k )
X (1) (! k )
for all k = 1; : : : ; K:
71
COMPLETE MARKETS
Our market M is
complete
if every possible payo is replicable,

2
1:05
6
6
6
6 1:05
6
6
4
1:05
for any
0
2
0
that is,
32
#
76 0 7
7
76
7
76
7
6
0 7 6 #1 7
7
7
76
5
54
#2
5
X (1) (! 1), X (1) (! 2), and
if there is a # such that

2
X (1) (! 1)
6
6
6
6 X (1) (! )
2
6
6
4
X (1) (! 3)
3
7
7
7
7
7
7
5
X (1) (! 3):
72
COMPLETE MARKETS
M is complete:
1:05
#
6
6 0 7
7
6
6
7
6
6
6 # 7 = 6 1:05
6
6 1 7
7
6
6
5
4
4
#2
1:05
0
2
0
3 12
0
X (1) (! 1)
7
6
7
6
7
6
7
0 7 6
6 X (1) (! 2)
7
6
5
4
5
X (1) (! 3)
3
7
7
7
7
7
7
5
73
THE SECOND FUNDAMENTAL THEOREM OF ASSET PRICING
The following statements are equivalent:
Both no-arbitrage and market completeness hold;
There exists one, and only one, risk-neutral probability Q.
74
A UNIQUE Q FOR OUR COMPLETE M
I
There is a unique triplet of strictly-positive masses Q (! 1), Q (! 2), and
Q (! 3) that meets the following constraints:
discounted Q expected nal prices

}|
1:05
6
6
6
1
6 1:05
1+0:05 6
6
4
1:05
0
2
0
3T
0
7
7
7
0 7
7
7
5
Q (! 1 )
6
6
6
6 Q (! )
2
6
6
4
Q (! 3 )
3
7
7
7
7
7
7
5
initial prices
}|
{
z
6
6
6
6 0 :5
6
6
4
2: 5
3
7
7
7
7
7
7
5
75
A UNIQUE Q FOR OUR COMPLETE M
The unique triplet is

2
Q (! 1 )
6
6
6
6 Q (! )
2
6
6
4
Q (! 3 )
02
3
7
7
7
7
7
7
5
B6 1:05
B6
B6
B
1:05 B6
1:05
B6
B6
@4
0
2
1:05
0:212 5
6
6
6
6 0:262 5
6
6
4
0:525
3T 1 1 2
1
0
6
7 C
6
7 C
6
7 C
C
7
0 7 C 6
6 0:5
C
6
7 C
4
5 A
2: 5
3
7
7
7
7
7
7
5
3
7
7
7
7
7
7
5
76
AN INCOMPLETE MARKET
The market
2
6
6
6
6 1:02
6
M0 = 6
6
6 1:02
6
6
4
1:02
0:5
0
2
0:10
7
7
7
7
7
7 ,
7
7
7
7
5
N + 1 = 2,
K = 3,
is incomplete.
77
AN INCOMPLETE MARKET
Indeed, the payo

2
X (1) (! 1)
6
6
6
6 X (1) (! )
2
6
6
4
X (1) (! 3)
6
7
6
7
6
7
7 = 6 1 :5
6
7
6
7
4
5
3
7
7
7
7
7
7
5
cannot be replicated:
02
1:02
B6
B6
B6
6
det B
B6 1:02
B6
@4
1:02
0
2
0:10
31
7C
7C
7C
C
1:5 7
7C =
7C
5A
1: 989 .
78
OUR INCOMPLETE M 0 IS ARBITRAGE-FREE
M 0 supports many risk-neutral probability measures:
discounted Q-expected nal prices

}|
6
1
1+0:02 4
1: 02
1: 02
3 6 Q (! 1 ) 7
7
1: 02 6
7
6
76
5 6 Q (! 2 ) 7
7
7
6
0 :1
5
4
Q (! 3 )
intial prices
z }| {
2
6
4
0 :5
3
7
5
m
2
6
4
1: 02
0
7
6
5 Q (! 1 ) + 4
1: 02
2
7
6
5 Q (! 2 ) + 4
1: 02
0:10
7
5 Q (! 3 )
2
6
1:02 4
1
0 :5
3
7
5
79
2
6
4
1: 02
0
7
6
5 Q (! 1 ) + 4
1: 02
2
7
5 Q (! 2 )
2
6
1:02 4
1
0 :5
6
4
7
5
1: 02
0:10
q
z
}|
{
7
5 Q (! 3 )
m
2
6
4
1: 02
0
1: 02
2
32
76
54
Q (! 1 )
Q (! 2 )
3
7
5
2
6
4
1: 02
1:02q
0:51
0:10q
3
7
5
m
2
6
4
Q (! 1 )
Q (! 2 )
3
7
5
2
6
4
1: 02
0
3 12
1: 02
1: 02
7
6
5
4
0:51
1:02q
0:10q
80
3
7
5
We have
6
4
Q (! 1 )
Q (! 2 )
7
5
1
1:02
6
6
4
32
1
2 76
74
5
1
2
1: 02
0:51
1:02q
0:10q
3
7
5
2
6
4
0:745
0:95q
0:255
0:05q
3
7
5
with the strict-positivity constraints

8
>
Q (! 1) = 0:745
>
>
>
>
>
<
Q (! 2) = 0:255
>
>
>
>
>
>
: Q (! ) = q > 0
3
0:95q > 0
0:05q > 0
q 2 (0; 0:784 210 53) .
()
81
NO-ARBITRAGE PRICING OF AN UNREPLICABLE PAYOFF
The no-arbitrage prices of the unreplicable payo

2
X (1) (! 1)
6
6
6
6 X (1) (! )
2
6
6
4
X (1) (! 3)
6
7
6
7
6
7
7 = 6 1 :5
6
7
6
7
4
5
3
7
7
7
7
7
7
5
are
2
1 (0:745
6
6
h
i
6
1
1
Q
f
6 1:5 (0:255
E X (1) =
1+r
1:02 6
6
4
0:95q ) +
0:05q )
2 q
7
7
7
+ 7
7
7
5
= 0:95588235q + 1:1053922 .
82
NO-ARBITRAGE PRICING OF AN UNREPLICABLE PAYOFF
The no-arbitrage prices range from
i
h
1
Q
f
inf
E X (1) =
inf
[0:955 882 35q + 1:1053922] = 1:1053922
Q 1+r
q2(0;0:784 210 53)
to
h
i
1
Q
f
sup
E X (1) =
sup
[0:955 882 35q + 1:1053922] = 1:8550052 .
Q 1+r
q2(0;0:784 210 53)
83
WHERE DOES THE UPPER BOUND COME FROM?
h
i
1
Q
f
1: 855 005 2 = sup
E X (1)
Q 1+r
V#u (0)
where
#u = arg minV# (0) subject to V# (1) (! k )
#
X (1) (! k ) in each state k:
#u denotes a minimum-cost super-replicating strategy.
V#u (0) is
f (1)
the minimum cost of super-replicating X
84
f (1)
MINIMUM-COST SUPER-REPLICATION OF X
The candidate super-replicating strategies # = [#0; #1]T solve the system
8
>
1:02 #0 + 0 #1
>
>
>
>
>
<
1:02 #0 + 2 #1 1:5
>
>
>
>
>
>
: 1:02 # + 0:10 #
2
0
1
the solution of which can be found graphically.
85
f (1)
8
>
r1
>
>
>
>
>
<
r2
>
>
>
>
>
>
: r
3
1:02 #0 + 0 #1 = 1
1:02 #0 + 2 #1 = 1:5
1:02 #0 + 0:10 #1 = 2
theta_1
14
12
10
8
6
r_2
4
2
-5
-4
-3
-2
-1
10
theta_0
-2
-4
r_1
r_3
86
f (1)
theta_1
14
12
10
(1.5 , 8)
g
tin
a
ic
pl
e
-r
er
p
su
r_2
)
(1
X
-5
-4
-3
-2
-1
10
theta_0
-2
-4
The strategy
r_1
r_3
[#0; #1]T = [1:5; 8]T
f (1) .
super-replicates X
87
f (1)
The initial-cost function of any strategy # is
V#(0) = #0 + #1 0:5 .
#0
0:5 :
c
Its level curve c is the straight line #1 = 0:5
theta_1
c=0
8
7
6
g
tin
a
ic
pl
e
-r
er
p
su
r_2
4
3
2
)
(1
X
1
-5
-4
-3
-2
-1
-1
theta_0
-2
-3
-4
-5
r_1
r_3
c = 1.855
88
f (1)
u ]T is the point of inI

The minimum-cost super-replicating strategy [#u
;
#
0 1
tersection between r2 and r3:
Hence, we must solve the system

8
u
u
>
< 1:02 #0 + 2 #1 = 1:5
>
: 1:02 #u + 0:10 #u = 2
0
1
to obtain
2
3
u
#
6 0 7
4
5
#u
1
6
= 4
1: 986 58
0:263 158
3
7
5
89
WHERE DOES THE LOWER BOUND COME FROM?

h
i
1
Q
f
1: 105 392 2 = inf
E X (1)
Q 1+r
V#l (0)
where
#l = arg max
#
V# (0) subject to V# (1) (! k )
X (1) (! k ) in each state k:
#l denotes a maximum-in ow strategy that generates a liability lighter than

f (1).
X
V#l (0) is
the maximum in ow from super-replicating
f (1)
X
90
MAXIMUM-INFLOW SUPER-REPLICATION OF
8
>
h1 : 1:02 #0 + 0 #1 =
>
>
>
>
>
<
f (1)
X
h2 : 1:02 #0 + 2 #1 = 1:5
>
>
>
>
>
>
: h : 1:02 # + 0:10 # = 2
3
0
1
theta_1
h_3
5
4
3
2
-3.0
-2.5
-2.0
-1.5
-1.0
su
-r
er
lic
ati
ng
-X
(1
ep1
-0.5
0.5
1.0
-1
1.5
2.0
2.5
3.0
theta_0
-2
h_2
-3
h_1
-4
-5
The strategy
[#0; #1]T = [ 0:25;
0:5]T
super-replicates
f (1) .
X
91
f (1)
X
The initial-in ow function of any strategy # is

f#(0) =
#0
#1 0 : 5
Its level curve f is the straight line
theta_1
V#(0)
#0
0:5 :
f
0:5
#1 =
).
5
4
3
g
tin
a
ic
p1l
e
-r
er
p
su
)
(1
-X
-3.0
-2.5
-2.0
-1.5
-1.0
-0.5
0.5
1.0
1.5
2.0
2.5
3.0
theta_0
-1
h_3
-2
-3
h_1
-4
h_2
f = 1.10539
f=0
-5
92
f (1)
X
I
The liability-type strategy [#l0; #l1]T is the point of intersection between h1
and h2:
I
Hence, we must solve the system

8
l
l
>
< 1:02 #0 + 0 #1 =
>
:
1:02 #l0 + 2 #l1 =
1
1 :5
to obtain
2
3
l
#
6 0 7
4
5
#l1
6
= 4
0:980 392
0:25
3
7
5
93
REPLICABLE PAYOFFS ADMIT A UNIQUE NO-ARBITRAGE PRICE
Consider the following replicable payo :

2
X (1) (! 1)
6
6
6
6 X (1) (! )
2
6
6
4
X (1) (! 3)
2: 04
7
6
7
6
7
6
7 = 6 4: 04
7
6
7
6
5
4
2: 14
3
7
7
7
7
7
7
5
Its no-arbitrage price does not depend on q :
h
i
1
Q
f
E X (1)
1+r
0:745
6
6
1 6
6 0:255
1:02 6
6
4
3T
0:95q
7
7
7
0:05q 7
7
7
5
2: 04
6
6
6
6 4: 04
6
6
4
2: 14
3
7
7
7
7
7
7
5
2: 5 .
94
OPTIMIZATION:
AN
INTRODUCTION
95
WEALTH ALLOCATION AND FINAL WEALTH
I
An investor allocates her initial wealth of 100 between a riskless security
( its net return is r ) and a risky security ( its net return is re ).
I
The proportion of initial wealth allocated to the risky security is w
The nal wealth achieved with the allocation w is
f
W
100 ( 1
w ) (1 + r)
100 ( (1 + r)
w (re
100 w (1 + re)
r) ) .
96
PORTFOLIO RETURNS AND BORROWING
The portfolio based on the allocation w yields a net return of
f
W
100
=
100
r + w (re
r) .
I
If the investor invests more than her initial wealth in the risky security
(w > 1), she needs to borrow:
| 1 {z w }
<
0 .
proportion allocated to the riskless security
97
THE RETURN ON THE RISKLESS SECURITY
Assume for now that
0% .
Hence, a purely riskless allocation (w = 0) implies
f
W
100
with
probability
1.
98
THE RETURN ON THE RISKY SECURITY
re
If
8
>
< g = 30%
>
: b
10%
0:25 ,
with probability mass
the expectation is
E [ re ]
with probability mass
0% .
Hence, a purely risky allocation (w = 1) implies
f
W
100 .
99
THE INVESTOR IS RISK AVERSE
I
If the investor were to pursue a purely riskless allocation (w = 0), she would
f = 100 (with probability 1)
get the following utility out of the nal wealth W
U ( 100 )
log ( 100 ) .
100
I
If the investor were to pursue a purely risky allocation (w = 1), she would
f = 100 ( 1 + re ):
get the following expected utility out of the nal wealth W
E [ log ( 100 (1 + re) ) ]
0:25
<
log ( 0:25
log ( 100 ) .
log ( 130 )
130
0:75
0:75
log ( 90 )
90 )
101
(expected) utility
p=1
4.86
4.84
4.82
(W
4.80
(W
4.76
)]
lo
g
4.78
4.74
[l
og
4.72
4.70
4.68
4.66
4.64
log ( 100 )
4.62
4.60
p = 0.25
4.58
4.56
4.54
4.52
p=0
4.50
70
75
80
85
90
95
100
105
110
115
120
125
130
135
140
145
150
wealth W
102
THE RETURN ON THE RISKLESS SECURITY
Assume
2% .
103
A POSITIVE RISK PREMIUM ON THE RISKY SECURITY
Consider
10%
0 :5
so that the risk premium is
E [ re ]
2%
8% .
The standard deviation of the risky return is
std [ re ]
20% .
104
OPTIMAL ALLOCATION WITHOUT PORTFOLIO CONSTRAINTS
Recall that the nal wealth is
f
W
100 ( ( 1 + r )
The optimal allocation is
+ w ( re
arg max E
w
r) ) .
log
f
W
105
242:86%
()
h
8
d
>
>
>
dw E
>
>
>
>
>
>
>
>
>
>
>
>
>
>
h
<
d E
dw
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
h
>
>
d
:
dw E
log
f
W
log
f
W
log
f
W
i
i
i
>0
w=w
<0
for w < w
=0
(stationarity)
for w > w
106
Recall that
f is always strictly positive:

w must be such that the nal wealth W
log x
8
>
100 ( (1 + r) + w (g
>
>
<
>
>
>
:
100 ( (1 + r) + w (b
is a real number only if
x>0 .
r) ) = 102 + w28 > 0

()
r ) ) = 102
w2
51 17
;
14 2
w12 > 0
107
h
d
E
log
dw
f
W
1
2
1
28
102 + w28
1
2
1
102
w12
12 )
108
1
2
1
28
102 + w28
1
2
1
102
w12
12 )
14 ( 102
w 12 )
( 102 + w 28) ( 102
6 ( 102 + w 28)
w 12 )
816
336 w
( 102 + w 28) ( 102
w 12 )
0
109
816
( 102 + w28 )
336w
( 102 w12 )
The denominator is striclty positive for
The numerator is non-negative for

17
7
w2
w2(
51 ; 17
14 2
1; 17
7 ]
with
242:86% :
110
expected utility
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
-5
-4
-3
-2
-1
1
-0.5
w*
10
allocation w
-1.0
111
WITH A PORTFOLIO CONSTRAINT ( w
1)
The investor cannot borrow to allocate more than 100 into the risky security:
= 1
expected utility
-5
-4
-3
-2
-1
10
allocation w
-1
112
1)
The portfolio constraint is binding at the optimum:
8
>
>
>
>
>
>
>
<
>
>
>
>
>
>
>
:
d E
dw
f
W
log
w=w
>
113
Let's introduce the Lagrangian function
L (w; l)
1)
log
f
W
l (w
1) .
l is the Lagrange multiplier with
0 .
114
1)
Let's use the Lagrangian function to re-express the optimality conditions:
8
@ L
>
>
>
@w
>
w=w ; l=l
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
l
0
>
>
>
>
>
<
>
>
>
>
>
>
@ L
>
>
0
>
@l
>
w
=
w
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
@ L
>
: l
= 0
@l
w=w
=)
8
h
i
d
f
>
>
E
log
W
>
dw
>
w=w
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
l = 0:041026 > 0
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
:
(w
= 0
1) = 0
(w
1) ) = 0
115
I
If the constraint is relaxed ( say to w
utility goes up by
h
d
E
log
dw
f
W
1)
1:01 ), the optimized expected
0:01
0:01 .
w=w
116
1)
expected utility 4.6850
4.6845
4.6840
about 0.00041
4.6835
4.6830
4.6825
4.6820
0.960
0.965
0.970
0.975
0.980
0.985
0.990
0.995
1.000
1.005
1.010
1.015
1.020
1.025
1.030
1.035
1.040
allocation w
117
The Lagrange multiplier
( optimized-expected-utility gain
is
1)
shadow price
0:041026 .
per
unit of constraint relaxation )
118
UNCONSTRAINED OPTIMIZATION
119
A PROFIT FUNCTION
I
A rm produces two outputs x and y (they can be sold at the xed prices
20 and 30, respectively).
The production costs are quadratic:
C (x; y ) = x2 + 2y 2
2xy + 20 .
The pro t function remains quadratic:
P (x; y ) = 20x + 30y
x2 + 2 y 2
2xy + 20
120
P 'S LEVEL CURVES
I
The level curve p = 300
pro t P (x; y ) equals 300.
is the set of output pairs (x; y ) such that the
y 70
60
50
40
30
20
10
0
0
10
20
30
40
50
60
70
121
P 'S LEVEL CURVES
The level curve
p = 600
is in black
y 70
60
50
40
30
20
10
0
0
10
20
30
40
50
60
70
122
P 'S LEVEL CURVES
I
The level curve p = 705
is the singleton (x = 35; y = 25), which is
the maximum-pro t production in the absence of constrains.
y 70
60
50
40
30
20
10
0
0
10
20
30
40
50
60
70
123
FIRST PARTIAL DERIVATIVE WITH RESPECT TO x
P (35 + h; 25)
Px (35; 25) = lim
h!0
h
P (35; 25)
= 0
It is the slope of P 's graph in (x = 35; y = 25) along the direction (x; y = 25)
700
650
600
profit level z
550
20
28
22
30
32
24
output y
34
26
36
38
28
40
30
output x
42
124
FIRST PARTIAL DERIVATIVE WITH RESPECT TO x
Px (35; 25)
@
20x + 30y
@x
(20
x2
2y 2 + 2xy
20
( x=35; y=25 )
2x + 2y )j ( x=35; y=25 )
125
FIRST PARTIAL DERIVATIVE WITH RESPECT TO y
P (35; 25 + k)
Py (35; 25) = lim
k!0
k
P (35; 25)
= 0
It is the slope of P 's graph in (x = 35; y = 25) along the direction (x = 35; y )
700
650
600
profit level z
550
20
28
22
30
32
24
output y
34
26
36
38
28
30
output x
40
42
126
FIRST PARTIAL DERIVATIVE WITH RESPECT TO y
Py (35; 25)
@
20x + 30y
@y
(30
x2
2y 2 + 2xy
20
( x=35; y=25 )
4y + 2x)j ( x=35; y=25 )
127
THE (NECESSARY) FIRST-ORDER CONDITIONS FOR OPTIMALITY
I
P : X
(x ; y ) 2 X .
R2
! R admits
rst partial derivatives at the interior point
I
If P has a local/global maximum at the interior point (x ; y ), then (x ; y )
is a stationary point for P :
Px ( x ; y )
Py ( x ; y )
0 .
128
THE HESSIAN MATRIX
I
If P : X
R2 ! R admits second partial derivatives at the interior
point (x0; y0) 2 X , then P 's Hessian matrix at (x0; y0) is
2
6
4
Pxx (x0; y0)

Pyx (x0; y0)
Schwartz's Theorem:
In our case, the Hessian is
Pxy (x0; y0)

Pyy (x0; y0)
3
7
5
Pxy (x0; y0) = Pyx (x0; y0) .
2
6
4
2
2
2
4
3
7
5
129
TAYLOR'S FORMULA STOPPED AT THE SECOND ORDER
I
Given any point (x0; y0), our quadratic pro t function can be re-expressed
as follows:
P (x; y )
P ( x0 ; y 0 )
Px (x0; y0)
(x
x
1 6
4
2
y
x0 )
Py (x0; y0)
3T 2
x0
Pxx (x0; y0)
7
6
5
4
y0
Pyx (x0; y0)
(y
Pxy (x0; y0)

Pyy (x0; y0)
y0 )
3
7
5
2
6
4
x
y
x0
y0
3
7
5
130
P 'S HESSIAN AT THE MAX. POINT (x = 35; y = 25)
P (x; y )
705
0 (x
35)
1
2
6
4
<0
for
x
y
any
0 (y
3T 2
35
7
6
5
4
25
x 6= 35
25)
2
2
or
( stationarity )
2
{z
3
7
5
y 6= 25
2
6
4
x
y
35
25
3
7
5
(negative de nite)
131
P 'S HESSIAN AT THE MAX. POINT (x = 35; y = 25)
Pxx (x ; y )
02
B6
det @4
Pxx (x ; y )
Pyx (x ; y )
Pxy (x ; y )
Pyy (x ; y )
31
7C
5A
<
02
B6
det @4
2
2
2
4
31
7C
5A = 4 > 0
132
THE (SUFFICIENT) SECOND-ORDER CONDITIONS FOR A LOCAL

MAXIMUM
I
P :X
R2 ! R admits continuous rst and second partial derivatives
in an open ball of the interior point (x ; y ) 2 X .
If (x ; y ) is a stationary point for P and if
P 's Hessian matrix at (x ; y ) is negative de nite,
equivalently, Pxx (x ; y ) < 0 and

02
B6
det @4
Pxx (x ; y )
Pxy (x ; y )
Pyx (x ; y )
Pyy (x ; y )
31
7C
5A > 0
then (x ; y ) is a local maximum point for P .

133
CONVEX SETS
I
X R2 is convex when the segment that connects two arbitrary points of
the set does not lie outside the set.
R2 is strictly convex (the connecting segment lies strictly inside R2).
( x; y ) 2 R
: x
0 ^ y
y
is convex:
here
-2
-1
-1
-2
134
P 'S STRICT CONCAVITY
I
P : X R2 ! R is strictly concave in its strictly convex domain X when
the segment that connects two arbitrary points of P 's graph lies strictly below the
graph.
600
400
profit level z
200
20
0
0
40
10
20
30
output y
60
output x
40
50
60 80
20x + 30y
x2 + 2 y 2
2xy + 20
is strictly concave.
135
I
P : X
R2 ! R is strictly concave in its strictly convex domain X
if and only if the non-empty sets f (x; y ) 2 X : P (x; y )
a g are strictly
convex .
y 50
level 300
40
level 600
30
level 700
20
10
0
0
20x + 30y
10
20
x2 + 2 y 2
30
40
2xy + 20
50
60
70
136
I
Assume that P : X
R2 ! R is twice derivable in all the points of its
open and strictly convex domain X .
I
P is strictly concave in X if and only if the Hessian matrix is negative
de nite in any point of X .
20x + 30y
x2 + 2 y 2
its Hessian 4
2
2
2
4
7
5
2xy + 20
is strictly concave:
is always negative de nite.
137
STRICT CONCAVITY
P :X
AND
THE UNIQUE GLOBAL MAXIMUM
R2 ! R is strictly concave in its strictly convex domain X .
I
If a local maximum point exists for P , it is also of global maximum and
unique.
600
400
profit level z
200
20
0
0
40
10
20
30
output y
60
output x
40
50
60 80
(35; 25) is the unique global maximum point.
138
C 'S STRICT CONVEXITY
I
C : X R2 ! R is strictly convex in its strictly convex domain X when
the segment that connects two arbitrary points of C 's graph lies strictly above the
graph.
100
80
60
cost level z
40
20
0
10
15
8
10
6
4
output y
5
2
0
The cost function
C (x; y )
output x
x2 + 2 y 2
2xy + 20
is strictly convex.
139
I
C : X
R2 ! R is strictly convex in its strictly convex domain X if
and only if
C is strictly concave there.
0
-20
-40
-60
-80
-100
10
15
8
10
6
4
5
2
0
x2 + 2 y 2
2xy + 20
140
I
C : X R2 ! R is strictly convex in its strictly convex domain X if and
only if the non-empty sets f (x; y ) 2 X : C (x; y )
a g are strictly convex .
y 10
level 120
level 80
8
7
6
level 40
5
4
3
2
1
0
0
x2 + 2 y 2
2xy + 20
10
11
12
13
14
15
is strictly convex.
141
MAXIMIZATION WITH EQUALITY CONSTRAINTS
142
RECALLING THE COST FUNCTION
I
A rm produces two outputs x and y (they can be sold at the xed prices
20 and 30, respectively) and its cost function is:
C (x; y )
x 2 + 2y 2
2xy + 20 .
143
A COST CONSTRAINT THAT DEFINES AN IMPLICIT FUNCTION
I
The output pair (x = 10; y = 10) commands a cost of 120. In a neighborhood of x = 10, the cost constraint
C (x; y ) = 120
implies the existence of a unique function
y =
( x)
such that
10 =
(10)
and
d
dx
C x ( x; (x) )
( x) =
.
C y ( x; (x) )
144
A COST CONSTRAINT THAT DEFINES AN IMPLICIT FUNCTION
output y
14
( 10 , 10 )
12
10
8
6
4
2
-5
-4
-3
-2
-1
10
11
12
13
14
15
16
17
18
-2
(10)
20
( level curve ) cost = 120
-4
10 =
19
output x
and
d
dx
C x ( 10; 10 )
( x)
x = 10
= 0
C y ( 10; 10 )
145
PROFIT MAXIMIZATION WITH A COST CONSTRAINT
The rm's pro t is
P (x; y )
20x + 30y
C (x; y )
The optimization problem is
max P (x; y )
x; y
subject to
C (x; y ) = a
146
From the constraint equation
C (x; y )
we can work out y from x via the implicit function
By plugging y =
( x) :
(x) into P , the problem becomes:
max P ( x;
x
( x) ) .
147
I
If P ( x; (x) )
must be stationary:
exhibits an interior extremum point, then such a point
dP
d
= Px + Py
=0
dx
dx
m
Px
=
Py
d
dx
m
Px
=
Py
Cx
Cy
148
The necessary condition for optimality
Px = Py
Cx = C y
holds if and only if there exists a real number

such that
Px
l Cx
Py
l Cy
(the
Lagrange multiplier )
149
By introducing the Lagrangian function
L (x; y; l; a)
P (x; y )
l (C (x; y )
a) ;
the necessary condition for optimality and the constraint can be expressed as
follows (stationarity for L):
8
>
Lx =
>
>
>
>
>
<
Ly
>
>
>
>
>
>
: L
l
=
=
Px
lCx
= 0
Py
lCy
= 0
(C
a) = 0
(constraint)
150
8
>
Lx = 0
>
>
<
>
>
>
:
Ly = 0
x 2 + 2y 2
|
20
2x + 2 y
l (2x
2y ) = 0
,
30
4y + 2 x
2x y + 20
{z
Ll = 0
l (4y
=0
}
2 x) = 0
8
>
x
>
>
>
<
>
>
>
>
: y
8
>
725
>
>
l
=
+
>
a 20
>
>
<
>
>
>
>
>
>
: l =
1
2
35
= l+1
25
= l+1
(select)
(discard)
725 2
a 20
151
725
a 20
35
l +1
25
l +1
1
2
35
25
20
725
20
725
1
2
1
2
152
L (x ; y ; l ; a )
P (x ; y )
l (C (x ; y )
|
{z
= 0
a)
P (x ; y )
1
(725) 2
(a
1
20) 2
a .
153
THE LAGRANGE MULTIPLIER l
d P
da
( x ; y
IS A
d
da
SHADOW PRICE
725
a 20
1
(725) 2
1
2
(a
1
20) 2
154
THE LAGRANGE MULTIPLIER l
IS A
SHADOW PRICE
If we x the cost constraint at a = 120 , then the shadow price is
1:6926 .
I
The rm is willing to surrender up to 1:6926 cents of pro ts to obtain a
1-cent relaxation of the cost constraint ( da = 0:01 ):
d
P( x ; y
da
0:01
0:01
'
1:6926 cents .
155
GRAPHICAL ANALYSIS WITH
a = 120
I
The optimal production is x = 12:9987 and y = 9:2848. The constrainedmaximum pro t is P (x ; y ) = 418: 5165:
( level curve ) profit = 418.52
output y
14
12
10
-5
-4
-3
-2
-1
10
11
12
13
14
15
16
17
18
19
20
output x
-2
-4
( constraint ) cost = 120
156
GRAPHICAL ANALYSIS WITH
a = 120
I
At the point (x ; y ) there is tangency
level curve and the maximum-pro t level curve:
P x (x ; y ) = P y (x ; y )
between the constrained-cost
C x (x ; y ) = C y (x ; y )
( level curve ) profit = 418.52
output y
14
12
10
-5
-4
-3
-2
-1
10
11
12
13
14
15
16
17
18
19
20
output x
-2
-4
( constraint ) cost = 120
157
OPTIMIZATION WITH INEQUALITY CONSTRAINTS
158
THE PORTFOLIO RETURN
The portfolio return is

rep
w1 re1 + w2 re2 + (1
w1
wj
fraction of initial wealth in the risky asset
rej
net return on the the risky asset
net return on the riskless asset .
w2 ) r
( j = 1; 2 ) ,
( j = 1; 2 ) ,
159
THE EXPECTED RETURN ON A PORTFOLIO
The expectation
E [ rep ]
is
T (w 1 ; w 2 )
r + w1 ( r1
rj
E rej
r ) + w2 ( r2
r) ,
( j = 1; 2 ) .
160
T 'S LEVEL CURVES
The allocation pairs (w1; w2) such that T (w1; w2) = 8%
are in black.
w_2
1.4
1.2
1.0
0.8
0.6
0.4
0.2
-1.4
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.2
0.4
0.6
-0.2
0.8
1.0
1.2
1.4
w_1
-0.4
-0.6
-0.8
-1.0
-1.2
-1.4
r1 = 12%; r2 = 8%; r = 2%:
161
T 'S LEVEL CURVES
The allocation pairs (w1; w2) such that T (w1; w2) = 10%
are in black.
w_2
1.4
1.2
1.0
0.8
0.6
0.4
0.2
-1.4
-1.2
-1.0
-0.8
-0.6
-0.4
-0.2
0.2
0.4
0.6
-0.2
0.8
1.0
1.2
1.4
w_1
-0.4
-0.6
-0.8
-1.0
-1.2
-1.4
r1 = 12%; r2 = 8%; r = 2%:
162
VARIANCES
AND
V ar rej
Cov [ re1 , re2 ] = (
CORRELATION
2
j
( j = 1; 2 )
163
THE VARIANCE OF A PORTFOLIO RETURN
The variance V ar (rep) is
V (w 1 ; w 2 )
3T
w1
6
7
4
5
w2
2w2
1 1
2
6
4
+ 2
2
1
1 2
1 2
2
2
1 2 w1 w2
3
7
5
2
6
4
w1
w2
3
7
5
2w2
2 2
for any portfolio choice (w1; w2) .
164
V 'S LEVEL CURVES
I
The allocation pairs (w1; w2) such that
black.
V (w1; w2) = (20%)2
are in
w_2
1
-1
w_1
-1
= 30%,
= 20%,
0 :5
165
V 'S LEVEL CURVES
I
The allocation pairs (w1; w2) such that
black.
V (w1; w2) = (10%)2
are in
w_2
1
-1
w_1
-1
= 30%,
= 20%,
0 :5
166
V 'S LEVEL CURVES
The allocation pair (w1; w2) such that

w1 = 0 ; w 2 = 0 .
V (w 1 ; w 2 ) = 0
is the point
w_2
1
-1
w_1
-1
= 30%,
= 20%,
0 :5
167
MAXIMIZING THE RISK-ADJUSTED EXPECTED RETURN
The investor's risk aversion is measured by the parameter
The risk-adjusted expected return on the portfolio is
J (w 1 ; w 2 )
1
A > 0
A
V (w 1 ; w 2 ) .
2
T (w 1 ; w 2 )
The problem is
max J (w1; w2)
w1 ; w 2
sub
( total risk exposure must not exceed q )

z
}|
{
w1
w2
168
I
If q = 3 , the constraint is painless and not binding with w1 = 107:4%
and w2 = 155:6% (the shadow price of the constraint is l = 0).
w_2
J's level curves
he
-1.0
-0.5
w_
1
re
0.5
+w
_2
=
1.0
1.5
2.0
2.5
3
3.0
w_1
-1
A=2 ;
= 30%;
= 20%;
0:5; r1 = 12%; r2 = 8%; r = 2%:
169
I
Given L (w1; w2; l) = J (w1; w2)
l (w1 + w2 q ) , the rst-order
conditions for constrained optimality can be written a la Kuhn-Tucker :
8
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
l
>
>
>
:
L w1
w1 ; w 2 ; l
= 0
L w2
w1 ; w 2 ; l
= 0
q=3
Ll
w1 ; w 2 ; l
0
0
Ll
w1 ; w 2 ; l
= 0
=)
8
>
>
>
>
>
>
J w1
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
J w2
>
>
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
:
w1 ; w 2 ;
= l
w1 ; w 2 ;
= l
w1 + w2
l = 0
3 < 0
170
The
8
>
>
<
>
>
:
The
feasibility
conditions are:
l
Ll
w1 ; w 2 ; l
( w1 + w2
complementary slackness
Ll
0 )
condition is:
w1 ; w 2 ; l
171
I
If q = 1 , the constraint is painful and binding with w1 = 47:4% and
w2 = 52:6% (the shadow price of the constraint is l = 4:63%).
w_2
w_
1+
J's level curves

w_
2=
[ 1.074 , 1.556 ]
1
1
he
-1.0
-0.5
re
0.5
1.0
1.5
2.0
2.5
3.0
w_1
-1
A=2 ;
= 30%;
= 20%;
0:5; r1 = 12%; r2 = 8%; r = 2%:

172
I
Given L (w1; w2; l) = J (w1; w2)
l (w1 + w2 q ) , the rst-order
conditions for constrained optimality can be written a la Kuhn-Tucker :
8
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
l
>
>
>
:
L w1
w1 ; w 2 ; l
= 0
L w2
w1 ; w 2 ; l
= 0
q=1
Ll
w1 ; w 2 ; l
0
0
Ll
w1 ; w 2 ; l
= 0
=)
8
>
>
>
>
>
>
J w1
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
J w2
>
>
>
>
>
>
<
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
>
:
w1 ; w 2
= l
w1 ; w 2
= l
w1 + w2
> 0
1 = 0
173
STOCK PRICING
174
THE DIVIDEND PROCESS
I The current date is t

I The stock pays out the dividend Xdt every `second' (a period of length dt)
I The dynamics of the dividend process is
dX =
a (X; t) dt
|
{z
b (X; t) dz
|
expected change Et [dX ]

where dz is Gaussian with Et [dz ] = 0 and Et
{z
unexpected change
h
dz 2
= dt
175
A FUNCTION OF THE DIVIDEND X AND ITS DYNAMICS
I S (X ) is a function of X
I Given the notation

d
SX =
S
dX
d2
SXX =
S ,
2
dX
and
we have
1
dS = SX dX + SXX b2dt
2
1
SX a + SXX b2
2 {z
|
dt
}
expected change Et [dS ]
S
b dz
| X {z }
unexpected change
176
EQUILIBRIUM STOCK PRICING
I The stock price is S (X )

I The per-annum expected total gain on the stock is
1
Et [dS ]
dt
+ X
expected capital gain + income gain
I In equilibrium, the following restriction holds true:

1 E [dS ]
dt t
+ X
Sr + SX b
I Sr is the cost of borrowing expressed in Euro (r is the riskfree rate)

I SX b
is the risk premium expressed in Euro
177
EQUILIBRIUM STOCK PRICING
I SX b
is the equity risk expressed in Euro
is the premium per unit of systematic risk
is the fraction of equity risk that is systematic.
178
TRENDING DIVIDENDS
I X 's dynamics is
dX = X
dt + X
dz
I X is expected to grow at the rate
IX=0
is an absorbing boundary
179
STOCK PRICING WITH TRENDING DIVIDENDS
I The equilibrium restriction is

1
SX X + SXX X 2 2 + X
2{z
|
}
Sr + SX X
1 E [dS ]
= dt
t
I If X = 0, the stock is worthless (it is unable to generate dividends):

S (0)
(boundary condition)
180
I The solution is
S (X ) =
(non-negative and meaningful i
r+
r+
> 0)
I Given the parabola

y( )
1 2 2
+
2
1 2
2
we impose
y (1)
(r +
<
181
I The elasticity of S (X ) with respect to X is

SX
X = 1
S
0
@
1
dS
S A
dX
X
I A 1% change in the dividend implies a 1% change in the stock price
182
I The total return on the stock is
dS
+
S
Xdt
r +
|
SX X
S
{z
expected total return
dt
}
SX X
S
dz
|
{z
}
unexpected total return
183
I The per-annum expected total return on the stock is
1 1
Et [dS ]
dt S
X
S
r +
r +
| {z }
per-annum dividend yield
SX
X
S
184
THE EXPECTED TOTAL RETURN ON A PORTFOLIO
I Our initial capital is H = 100 Euro. We invest 60 Euro in the stock and
40 Euro in the riskfree asset
I The per-annum expected total gain is

1
Et [dH ]
dt
60 1
Et [dS ] + X
S dt
60 (r +
+ 40r
+ 40r
I The per-annum expected total return is

1 1
Et [dH ]
dt H
r +
60
100
185
RATIONAL BUBBLES
I Another solution to
1
SX X + SXX X 2 2 + X
2
Sr + SX X
with
S (0) = 0
is given by
S (X )
r+
|
{z
}
fundamental value
c X
{z
}
bubble
positive constant
1
+
2
"
1
2
+2 2
#1
2
>
186
RATIONAL BUBBLES
I The elasticity of S (X ) with respect to X is `excessive':
SX
X
S
( 1
S
1) cX
>
187
THE COEFFICIENT

y (1)
y ( ) = 12 2 2 +
(r +
<
1 2
2
and
y ( 1)
_1
ma
gam
- ( r + sigma*lambda*rho - mu ) < 0
we have
gamma
188
`POWER' STOCK PRICING
I The stock that pays out X 2dt every `second' has the following equilibrium price:
P (X ) =
X2
r+2
2 + 2

y( )
1 2 2
+
2
1 2
2
we impose
y (2)
r+2
2 + 2
<
189
`POWER' STOCK PRICING
I The total return on the stock is
dP
+ X 2dt
P
r +
|
PX X
P
dt
{z
expected total return
(r + 2
) dt
PX X
P
dz
|
{z
}
unexpected total return
2 dz
190
MEAN-REVERTING DIVIDENDS
I X 's dynamics is
dX =
k (X
m) dt + X
dz
I The long-run mean is E [X ] = m > 0

I k > 0 is the speed of mean reversion
I If k ! +1, X remains xed at the level m
I X = 0 is a re ecting boundary
191
STOCK PRICING WITH MEAN-REVERTING DIVIDENDS
I The per-annum expected capital gain is

1
Et [dS ]
dt
SX ( k (X
1
m)) + SXX X 2 2
2
I The equilibrium stock price solves

1
Et [dS ] + X
dt
Sr + SX X
and is
S (X ) =
m
k
X
+
r r+
+k r+
+k
192
STOCK PRICING WITH MEAN-REVERTING DIVIDENDS
I The absence of mean reversion brings us back to the trending-dividends case

(without growth):
X
lim S (X ) =
k!0
r+
I A massive mean reversion brings us back to the riskless case (without growth):
lim S (X ) =
k!+1
I Systematic risk and risk aversion (

E [ S (X ) ]
m
r
> 0) do have a long-run impact:

m
k+r
r r+
+k
<
m
r
193
APPENDIX
194
THE CAPITAL ASSET PRICING MODEL
I The stock market portfolio is worth M with dynamics

dM + XM dt
M (r +
) dt
I The premium for systematic risk (expressed in Euro) is M
M dzM
I The CAPM states

1
Et [dM ] + XM
dt
Mr
+
|
covt [dM; dM ]
vart [dM ]
{z
`beta' equal to 1
195
THE CAPITAL ASSET PRICING MODEL
I For the single stock, the CAPM states

1
Et [dS ] + X =
dt
Sr
+
|
covt [dS; dM ]
vart [dM ]
{z
M
}
X b
`beta' equal to SM
Sr
SX b
196

QMF Lectures 2013-14

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QUANTITATIVE METHODS FOR FINANCE

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

THE COURSE MATERIAL IS ON BLACKBOARD (BB)

Enroll in a BB course by entering your I-Catt URL (www.i-catt.it).

You enter BB via http://blackboard.unicatt.it.

Your BB username is: surname.IDnumber. Your BB password is: utente.

For any problem, contact supporto.blackboard@unicatt.it.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

No-arbitrage pricing of assets replicated by existing traded securities.

No-arbitrage pricing of unreplicable assets.

Constrained optimization with applications to nance/economics.

Equilibrium valuation of assets.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

I IS THE NEUTRAL ELEMENT OF THE MULTIPLICATION

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

TRANSPOSITION AND MULTIPLICATION

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

INVERSE AND INVERTIBLE MATRICES

If it exists, the inverse of an n n matrix C is an n n matrix C 1 satisfying

n matrix C is invertible if its inverse matrix C 1 exists.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

DETERMINANTS OF SQUARE MATRICES

= 1 ( 1)1+1 det (3) +

1 ( 1)2+1 det (2)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

DETERMINANTS OF SQUARE MATRICES

CONSTRUCTING THE INVERSE MATRIX

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

CONSTRUCTING THE INVERSE MATRIX

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

( 1)1+1 det (3)

( 1)1+2 det (1)

( 1)2+1 det (2)

( 1)2+2 det (1)

CONSTRUCTING THE INVERSE MATRIX

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

A FORMULA FOR INVERTING 2

cb 6= 0, consider the square matrix

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

SYSTEMS OF LINEAR EQUATIONS (REVIEW)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

We can rewrite it as follows:

We can also rewrite the system as a `constrained' linear combination:

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

The system admits a solution i the vector

can be seen as a linear combination of the vectors

with proper weights x1, x2, and x3.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

This can happen i (Rouche-Capelli Theorem)

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

The rank of a matrix is the highest order of non-singular square submatrices.

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

Let's express it as follows:

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

The rst three vectors are independent:

Alessandro Sbuelz - SBFA, Catholic University of Milan - A.Y. 2013-14

If the fourth vector is brought on the right-hand side,